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CA Foundation · Business Economics · Determination of National Income

In a simple Keynesian model, why is the multiplier effect of a given rise in government expenditure greater than that of an equal cut in lump-sum taxes?

Government spending raises aggregate demand by the full amount in the first round, whereas a tax cut raises disposable income and households spend only a fraction, the MPC, saving the remainder. The smaller first-round injection makes the tax multiplier smaller in magnitude than the spending multiplier.

  1. ATaxes are always spent entirely by households
  2. BGovernment spending adds fully to aggregate demand in the first round, while a tax cut raises it only by MPC times the cutCorrect
  3. CThe tax multiplier is always larger than the spending multiplier
  4. DA tax cut increases savings by the full amount of the cut

Explanation

Government spending directly adds the whole amount to expenditure in round one. A tax cut raises disposable income, but households spend only the MPC fraction and save the rest, so the first-round addition is smaller. Hence the tax multiplier magnitude, MPC/(1-MPC), is one less than the spending multiplier.

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